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MODULE 5: AGGREGATE DEMAND AND AGGREGATE SUPPLY
106 2.0. Objectives
At the end of this Unit, you should be able to:
Understand the meaning and nature of aggregate demand.
Understand the meaning and nature of aggregate demand Curve
Know the differences between short-run and long-run aggregate demand and supply.
3.0. Main Content
3.1 Meaning of Aggregate Demand
In this unit we shall define what is aggregate demand and aggregate demand curve. So let us start by defining aggregate demand. Aggregate demand is the total demand for goods and services in the economy. Aggregate demand is usually equal to planned expenditure. Aggregate demand is national income denoted as Y and planned expenditure is the addition of consumption expenditure (C), investment (I) and government consumption expenditure (G). Y = C + I + G 3.1.1. Aggregate Demand Curve
Having defined aggregate demand, let us take a look at how the aggregate demand curve looks like. The aggregate demand curve shows the relationship between short-run equilibrium output, ‘Y’, (which equals planned aggregate spending) and price level, ‘P’ or inflation. However, it should be noted that the relationship is a negative one, implying that an increase in price level will lead to a decrease in aggregate output and vice versa. More so, we can conclude that the name of the curve reflects the fact that short-run equilibrium output is determined by total planned spending or demand in the economy. We can then get the relationship between the short-run equilibrium output and price level shown in figure 3.1 but the overall price level is on the vertical axis and the aggregate output is on the horizontal axis.
Let us take a look at the graph of aggregate demand curve from figure 3.1 bellow.
We can see that the aggregate demand (AD) curve is downward-slopping;
depicting a negative relationship between output and price level (or inflation).
Therefore we can say that an increase in the price level will reduce short-run equilibrium output. But it should be noted that the AD curve can either be straight or curving.
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Figure 1: Diagram showing the Aggregate Demand Curve
Note that the AD curve is not the sum of all the market demand in the economy. It is not a market demand curve. It is different from an ordinary demand curve in the sense that the logic behind the ordinary demand curve is that when price of a commodity changes, ceteris paribus, the prices of all other commodities will not change. However, in the case of aggregate demand curve this logic does not follow, because when the general price level changes every other prices like wages (price of labour), commodity prices and interest rates will change. Given this, the logic that explains why a simple demand curve slopes downward fails to explain why the AD curve also has a negative slope. Note that the AD curve shows a negative relationship between a short-run equilibrium output and price level (inflation). Economists sometimes define the AD curve as the relationship between aggregate demand and the price level rather than inflation.
Self Assessment Exercise
With the aid of diagram discuss the aggregate demand curve.
3.2. Reasons for the downward sloping of the Aggregate Demand Curve
a. Monetary Authority Response: Let us consider the situation when inflation is high, the monetary authority (Central Bank of Nigeria (CBN), in the case
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of Nigeria) responds by raising the interest rate. The increase in interest rate reduces consumption and investment spending (autonomous expenditure). The reduction in consumption and investment spending in turn reduces short-run equilibrium output. The higher inflation which led to a reduction in output makes aggregate demand curve to be downward slopping.
b. Effectiveness of Money Supply and Demand on Interest Rate: Aggregate demand falls when the price level increases because the higher price level causes the demand for money (Md) to rise. With money supply constant, the interest rate will rise to re-establish equilibrium in the money market. It is the higher interest rate that causes aggregate output to fall. Thus, in the end, the increase in the price level will lead to a fall in aggregate output, which gives a negative relationship between the two.
c. Consumption Expenditure: Consumption expenditure tends to rise when interest rate falls and fall when interest rate rises, just as planned investment does. The consumption link is another reason for the downward slopping shape of AD curve. An increase in general price level increases the demand for money, which in turn leads to an increase in the interest rate. A rise in interest rate causes a decrease in consumption as well as planned investment, which consequently leads to a decrease in output or income.
d. Analysis of Real Wealth Effect: Consumption depends on wealth (that is, holding of money, shares, housing, stocks, etc) other things being equal, the more wealth households have, the more they consume. If household wealth decreases, the result will be less consumption now and in the future.
The price level has an effect on some kinds of wealth. For example, an increase in the price level leads to decrease in purchasing power and lowers the real value of some types of wealth such as stocks, housing etc.
however, the effect of a rise in general price level on wealth depends on what happens to stock prices and housing prices when the overall price level rises. If these two prices rise by the same percentage as the overall price level. The real value of stocks and housing will remain unchanged and this will lead to a decrease in consumption, which leads to a decrease in aggregate output. Thus, there is a negative relationship between the price level and output through this real balance effect.
e. The uncertainty in the Economy: During period of inflation, aggregate demand falls because in uncertain economic environment both households and firms may become more cautious and reduce their spending.
f. Foreign Price of Domestic Goods: A final link between the price level and total spending operates through the prices of domestic goods and services sold abroad. The foreign price of domestic goods depends in part on the rate at which the domestic currency exchanges for foreign currencies.
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However, for constant exchange rate between currencies, a rise in domestic inflation causes the prices of domestic goods in foreign markets to rise more quickly. As domestic goods become relatively more expensive to prospective foreign purchasers, export sales decline. Since net exports are part of aggregate expenditure, so we find that increased inflation tends to reduce spending and cause the AD curve to slope downward.
Self Assessment Exercise
Discuss the reasons for the downward sloppy of aggregate demand curve.
4.0 Conclusion
We can conclude from this unit that aggregate demand is the total demand for goods and services produced in the economy over a period of time while aggregate demand curve shows the relationship between short-run equilibrium outputs, which is the equals planned aggregate spending and price level or inflation.
5.0 Summary
In this unit, you have been learnt that the meaning of aggregate demand and aggregate demand curve. Finally we can conclude that aggregate Demand represents the total demand for goods and services in an economy. By defining aggregate demand in terms of the price level and output or income, it is possible to analyze the effects of other variables, like the interest rate, on aggregate demand through an aggregate demand equation.
6.0 Tutor-Marked Assignment
1. Aggregate demand is the total demand for goods and services produced in the economy over a period of time. Do you agree with the statement? Discuss
2. With the aid of diagram, discuss the analysis of aggregate demand curve.
3. Discuss the impact of aggregate demand in the economy.
7.0 References/Further Readings
Folawewo A. (2009) Introductory Economics (2009), Ibadan Distance learning Series, university Press Ibadan.
Yahyah, R. (2011) Introduction to macroeconomics theory, 1st edition, Landmark Publication Limited.
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